CEO compensation: The sky is the limit

Factors unique to life insurers

Relative to their peers in the financial services sector, says Gayley, CEO compensation at life insurers is “solidly positioned in the middle of the pack,” a result mirrored in the insurers’ performance relative to that of other financial services companies.

Experts note, however, that life insurers use a broader array of financial metrics than do businesses in other sectors to help determine pay. One reason: The insurers have more audiences to satisfy — among them government overseers — because of their exposure to potentially significant losses that can undercut their ability to make good on obligations to policyholders. Hence the heightened need to control, manage and recognize risk in their executive comp programs.

Among the publicly held companies, the stakeholders include not only shareholders and federal regulators, but also state regulators. The companies therefore report financial results using generally accepted accounting principles for the SEC and statutory accounting principles for the National Association of Insurance Commissioners.

Doing well using one set of accounting standards doesn’t necessarily translate to positive financial results for the other. The benchmarks are employed to guide pay, Gayley notes, and thus have to carefully balance the results of both reporting methods.

“In the life insurance business, the name of the game is fundamentally trying to prove your financial viability to both policy owners and other stakeholders,” he says. “So the financial scorecard for the life companies tends to be more varied than in other industries.”

In addition to metrics commonly used by publicly held companies — total shareholder return, return on equity, earnings per share, revenue and net income, among others — the life companies also tap some metrics that are unique to its industry. Example: the risk-based capital (RBC) ratio of total adjusted capital to total risk-based capital, a measure used to indicate whether a company’s capital reserve is adequate given the degree of risk a company has assumed.

When reviewing year-over-year revenue growth, the life companies also don’t necessarily attach equal weight to the sources of income. An extra dollar in premium for products that meet an insurer’s targeted mix of profitability, capital allocation, return on investment and risk may be of greater value than premium from solutions viewed as less strategically significant.

Financial metrics for the industry also continue to evolve. One that’s likely to be more widely adopted in coming years, says Gayley, is economic or risk-adjusted capital.

“Life insurers and other financial services institutions use this measure to adjust the capital base and capital allocated to the different divisions of their business to reflect the variable risks these divisions present,” he says. “Companies also use the metric to effectuate returns from each of the units relative to the risk-adjusted capital base.”

Other metrics have fallen out of favor. Case-in-point: Economic value added (EVA), or a measure of a company’s economic performance based on residual wealth calculated by deducting the cost of capital from its operating profit (adjusted for taxes on a cash basis). 

“Almost every large company previously went to an EVA reporting system,” says Dorf. “The problem is there are 106 variables that go into calculating the metric. Few people could understand it.

“EVA died a horrible death,” he adds. “The reality is this performance measure is fraught with problems and doesn’t work. But people are always looking for a better mousetrap.”

The diversity of metrics used by life insurers — ISS counts 20-plus long-term benchmarks and nearly 40 short-term ones — points to an ongoing issue: The difficulty in comparing awards across businesses because each company has a unique formula for calculating realizable pay. The one existing standard, SCT pay, is a combination of actual pay (salary and annual incentives) and target pay for long-term awards.

This disadvantage aside, some observers believe that companies should favor SCT over realizable numbers because of the former’s relative simplicity.

“We prefer to stick with the SEC-mandated disclosures found in summary compensation tables in keeping with our KISS philosophy — keep it simple, stupid!” says Kevin McManus, editor and president of ProxyTell LLC, a proxy advisory firm. “We use these numbers because they’re easy, simple and accurate.

“[Realizable pay] is something compensation advisors push…not that there are not advantages to the realizable pay metric,” he adds. Among the benefits, McManus notes, is the ability to lower compensation relative to that reported using other metrics and thus more easily “sell” CEO pay to outside stakeholders.

Yet another complication in evaluating pay is the anomalies, such as when a company pays above target to a newly hired CEO to turn the business around. In the early going, the executive’s compensation may not seem justified given the company’s revenue or profit margin. Hence the need to ensure an apples-to-apples comparison among firms of relatively equal financial strength, business prospects and objectives when evaluating CEO rewards.

The value of transparency

Given the heightened scrutiny of CEO compensation in recent years, companies are now also disclosing financial metrics and objectives (including the relative weight assigned to each) in advance of payouts to ensure that subsequent awards don’t raise alarm bells with investors, regulators or the public. This contrasts with years past, when companies would review performance metrics at the close of the year and only then make a determination on pay.

“Companies are adding structure to compensation formulas to provide shareholders and other stakeholders with more information about how the company’s executive pay program will work,” says Semler Brossy’s Baransky. “These structures provide greater clarity about how pay is determined.”

The advance planning around metrics dovetails with a best practice that Gayley promotes among his insurer clients: The need to exercise discipline in goal-setting, both relative to past performance and to the financial results of competitors, and to maintain discipline when business conditions are unstable. Conducted in tandem with this goal-setting is a discussion of long-term awards for CEOs within the context of the company’s risk tolerance and expected return.

“The internal dialogue around risk and returns, in particular, and how they relate to goal-setting, continues to improve, not only because management is very focused on it, but also because the regulators are focused on it,” says Galey. “The dialogue with regulators around risk-related issues has been richer and more explicit over the past several years than during the 2008-2009 period.”

Future guardrails around pay

That’s to be commended. Yet, questions persist as to whether companies need more internal or external checks to ensure that CEO comp is aligned with stakeholder interests. In the absence of industry-wide standards for calculating realizable pay, for example, might there still exist opportunities for company boards to manipulate goals and metrics for, say, political reasons, to keep their CEOs and fellow execs financially happy?

Market-watchers inquire, too, whether some financial services companies might be tempted to take unwarranted risks (e.g., with their hedging and trading strategies) to meet unreasonably high performance measures.

“If you have to improve earnings by 10 percent to secure a target payout, then you could end up with traders taking bigger risks to hit that number,” says Hall. “The possibility that companies may take greater financial risk to boost executive comp is a concern the federal government has raised.”

And there is this question: In a business and economic environment characterized by cut-throat competition, rapid-fire advances in technology, shorter product life cycles, rising investor expectations and a limited executive talent pool to manage it all, might company boards feel compelled to boost CEO pay so high as to negatively impact (among other things) their ability to recruit, reward and retain others lower down the pay scale?

Alas, only time will tell.